Online Library of Liberty: Economics, vol. 2: Modern Economic Problems

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PART II

BANKING AND INSURANCE

CHAPTER 7

THE FUNCTIONS OF BANKS

§1. Nature and classes of banks. § 2. Functions of banks. § 3. The essential banking function. § 4. Demand deposits. § 5. Discount and deposit. § 6. Nature of banking reserves. § 7. Time deposits. § 8. Bills of exchange, domestic. § 9. Issue of notes. § 10. Divergent views of typical bank-notes. § 11. Banking credit as a medium of trade.

§12. Productive services of banks. § 13. Earnings of banks.

§1. Nature and classes of banks. A bank, as one first comes to know it, is a building (or a room in some building) in which there is a fireand burglar-proof safe. In this room are men receiving and paying out money and acting as bookkeepers. Usually, however, the word bank means, not the building, but the business organization or the enterprise as a whole. Banks perform a variety of useful functions in every modern community. All these functions touch in some way upon the use of money, and banking problems always are related to money problems. It is our purpose now to understand the nature and work of banks in relation to the general business activity of the community.

In the United States there were on June 30, 1920, more than 30,000 banks reported. These may be classified first according to the source from which they derive their charters or authority to do a banking business as: national, state, and private. The last are unchartered and act under the general state laws governing private contracts; in general they are unsupervised.1 Banks may be classified also, according to the two main types of business they perform, as banks for savings and commercial banks. Most banks do mainly a general commercial business; some are distinctly banks for savings; but in truth this dividing line can be less and less sharply drawn between banks as units; rather the distinction must be made between the savings function and the commercial discount function, which are more and more being performed by one and the same bank. The statistical data collected in the United States distinguish only imperfectly between these two. The trust company usually unites these two functions in large degree. This matter will be better understood in connection with the analysis of the functions that banks perform, now to be given.2

§ 2. Functions of banks, incidental. Almost every bank performs various functions useful to its customers, but some of which are not essentially bound up with banking, and may be performed by institutions that are not truly banks. Among these are:

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(a)Maintaining a safe-deposit vault, where space may be rented by an individual to keep his valuable papers, jewels, etc. The customer does not usually deliver to the bank possession of the valuables, but himself retains the key to the box, which the bank has no right to open. In larger cities this work is often done by separate institutions.

(b)Acting as money-changer to buy and sell moneys of different nations. This function is of less importance in America than elsewhere because of the great size of our country and of the small portion of our boundaries touching those of other nations using different monetary units. Moreover, the function is in large part performed for Americans by ticket agencies at the ports of embarkation and by the steamship companies en route.

(c)Selling bonds and other investments to customers. In smaller communities the customers of a bank turn to it as the best source of information for safe investments of personal or trust funds. This opens to it a new possibility of service. Large investments, however, are usually made through the agency of more specialized investment brokers.

(d)Acting as trustee and business manager for passive investors, and especially as executor and administrator of estates or as guardian of a minor heir. This function was taken up rapidly after about 1890 by trust companies3 organized under state laws, and after 1918 (as a result of an act of Congress) by many national banks.

(e)Receiving time deposits at a low rate of interest to lend or invest in securities at a higher rate of interest. Such time deposits are not subject to withdrawal by customer’s check, excepting after notice to the bank (if required). Receiving time deposits is the essential function of savings banks (as distinct from commercial banks) and will be more fully discussed in a later chapter.

(f)Selling its credit, that is, giving its promise to pay at some other place, or at some other time, in return for a payment that yields a profit.

§ 3. The essential banking function. The one essential function of a bank is selling (lending) its credit to its customers in some form that will conveniently serve the same function as money. A bank of this kind is sometimes described as a business whose income is derived from lending its promises. The bank’s credit is sold in the form of its promises, the evidences of which are its receipts, depositors’ account books, drafts and checks on other banks, and banknotes. The indispensable condition to the exercise of this function by a bank is public confidence in its abilty to fulfil its promise to pay whenever it is due. This confidence is built upon the bank’s paid-up capital; its surplus and undivided profits; the further liability of the stockholders to make good any losses up to an amount equal to the capital stock each holds (“stockholder’s double liability”); the financial prestige of the bank’s officers, directors, and stockholders; the bank’s established reputation and “good will” in the community after a period of successful operation; the character of its loans and of the securities which it owns; and, finally, the reliance placed upon the control and inspection by official examiners. The bank then may (in addition to receiving time deposits) sell its

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credit in any one or in all of the following four ways: (1) by receiving demand deposits; (2) by the method of discount and deposit; (3) by selling exchange of funds to distant points; (4) by issuing banknotes.

§4. Demand deposits. Demand deposits are those payable on demand, the demand in practice being by means of personal checks requesting the bank to pay to (or on the order of) a specified person, or to pay to bearer. A customer’s bank account consisting of demand deposits is called a checking account. Since the turn of the century it has become increasingly the practice to pay a low rate of interest (about 2 per cent) on current balances, oftener to large depositors. Banks attract demand deposits mainly by the convenience and economy which they offer to their customers in the guarding of funds from theft and fire and in saving the time, trouble, and expense of carrying money for making payments. A deposit in a bank is to the depositor for most purposes “just as good” as money in the pocket and for many purposes is even better. Thus the banks have become the custodians of a large proportion of the money (or funds) needed for current use by individuals and business corporations. Large amounts of deposits (though only a small proportion of the total) are brought to the banks in the form of bags and rolls of money, or as funds consisting of credit papers, such as checks and drafts, calling for the payment of money. But most deposits are created in another manner now to be described.

§5. Discount and deposit. The process of discount and deposit is the purchase of the promissory note of a customer,4 the price being a credit in the form of a demand deposit on the books of the bank. This—the central and most characteristic banking operation—has something of mystery in it at first view. In simple deposit, described in the last section, the bank becomes the debtor and the depositor becomes the creditor of the bank. But in discount and deposit the depositor brings no money, and the credit paper that he gives is his own promise to pay, whereby he becomes the bank’s debtor. For example, when a bank discounts a $1000 note for three months and credits its customer with the proceeds, its deposits are at that moment increased (let us say) $985. Notice that hereby the bank does not add a cent to the cash in its vaults while it has added to its liabilities payable on demand. As an offsetting asset it holds the note of its customer receivable at some future time. Most of the loans and discounts of commercial banks serve thus to create deposits, and the two items (loans and deposits) rise and fall in about the same ratio. In 1920 in all reporting banks (exclusive of the twelve Federal Reserve banks) individual deposits were $38,000,000,000 and loans were $31,000,000,000.

§6. Nature of banking reserves. Banks would have nothing to gain by receiving deposits or by issuing notes if they were obliged to keep in the vaults actual money to the amount of their deposits and outstanding notes (unless they were paid by depositors for taking care of deposits). It was found necessary in practice for banks to keep on hand money amounting to only a fraction of all their outstanding obligations in order to be able to pay promptly all due demands under ordinary business conditions. The sum thus kept on hand is called the reserve or the reserves of the bank, and this is frequently expressed as a percentage of reserves against deposits or against note issues, respectively, or of both together. Frequently, as in the United States, a minimum percentage of reserves is fixed by law.5

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A bank’s reserves consist, first, of the lawful money that it actually holds in its vaults at any moment, and, secondly, of certain other credit items in other banks or with the government, of such a nature that a bank is permitted to count them as though immediately available.

The explanation of the adequacy of a mere fractional reserve is found in the nature of the individual monetary demand6 and in the effective way in which a checking account serves as a substitute for actual money.7 Every customer, if he would avoid overdrawing his account, must at most times keep a goodly balance to his credit that he does not immediately need. Many individuals and corporations must at times keep very large balances. The times of maximum monetary need of the customers of a bank never exactly coincide, and many payments are made among the customers of a single bank, requiring only bookkeeping transfers. A fractional reserve is therefore ordinarily fully adequate, although with any less than 100 per cent reserve any bank would be insolvent if all of its demand obligations were presented at the same instant. Such an extreme condition is made impossible by business custom and public opinion, especially among the larger customers of banks; but the panic of small depositors and the urgent need of larger ones often bring about a dangerous situation, in which banks with abundant assets find their reserves nearly or quite exhausted. To prevent the breakdown of the separate banks and of the whole banking system at such times, by providing ways of replenishing the reserves, is a large part of the “banking problem.”

§7. Time deposits. Time deposits are funds to the credit of customers which, by agreement, are to be left for some specified minimum time or on condition that the bank may require notice in advance of the depositor’s intention to withdraw them. The notice that may be required is usually from thirty to ninety days; but only in times of general financial crises or of runs on particular banks is this requirement enforced. A sufficient deterrent to irregular withdrawal of funds is usually found in the loss of interest if deposits are withdrawn at other than stated times. The bank’s right to require notice makes prudent the investment of a much larger proportion of its deposits and for a longer time; it reduces the proportion of deposits needed for reserves, and yet reduces the danger of a “run” upon the bank in time of financial distress. These are reasons why banks can and usually do pay interest on time deposits (at from 2 to 4 per cent), as until more recently they rarely did on demand deposits. From the standpoint of the depositor a time deposit is, by its very nature, an investment and not a demand credit available for current monetary uses. Only that portion of a person’s capital that for some more or less considerable period is not likely to be needed for other purposes ought to be put into time deposits. A bank, however, is generally a much safer place in which to keep a fund of purchasing power for the future than is the strongest private treasure-box. Receiving time deposits is the one essential function of savings banks, but this function is increasingly performed by other banks.8 In some cases time deposits are cared for by a separate department and kept separate from the general business of a commercial bank.

§8. Bills of exchange, domestic. Foreign and domestic exchange is the sale of orders for the payment of specified sums of money at distant points. But for this, payments at distant points would ordinarily have to be made by sending the money in some way. It

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must often occur, for example, that hundreds of payments, aggregating millions of dollars, must be made by persons in and near Chicago to those in and near New York, while, at the same time, equally large sums are due from New York to Chicago. The wasteful process of shipping these sums back and forth is avoided by the cancellation of indebtedness between the two localities. It has been the practice for each small bank to keep a part of its funds in correspondent banks in one or more of the larger cities on which it draws bills of exchange for its customers and to which in turn it remits for collection drafts and checks which it has received. Before 1914 such deposits might, up to a certain percentage, be counted as part of the depositing bank’s legal reserves. From time to time, as balances of accounts increase on the one side or the other, shipments of actual money become necessary; but these are only a small fraction of the total amount of the bills of exchange mutually cancelled. Similarly, the settlement of accounts between any two localities can be made by the shipment of comparatively small sums of money. Under the Federal Reserve Act the reserve banks have in various ways assumed the functions of the correspondent banks, aiming to bring about parity of checks issued in any part of the country.

The wider use and acceptance of individual checks at long distances from the banks upon which they are drawn limit by so much the proportion of special bills of exchange drawn by the banks themselves. Domestic exchange involves just the same principles as foreign exchange of funds, except that in the latter, usually, two different units of standard money are used. In connection with the discussion of foreign trade below, foreign exchanges will be explained and further light will be thrown upon the adjustment of the money supplies and levels of prices of the various sections of a single country, as well as between different countries.

§ 9. Issues of notes. The issue of bank-notes as a mode of lending a bank’s credit calls for consideration here. Yet it must be observed at once that comparatively few banks in the world have now the legal right to issue their own notes. The function of banknote issue has come to be looked upon as so closely connected with that of the coinage and regulation of the standard money that it has been increasingly limited in each country to a central national bank, or group of banks, which is in many respects practically an organ of the government. To such banks the right of note issue is granted as a monopoly in return for specified payments and services. In normal times the issues of bank-notes are regulated by the banks themselves; but in times such as those following the outbreak of the World War the bank-note issues become essentially political money (irredeemable) issued by command, and to meet the urgent financial needs, of the sovereign state.

No two countries have quite the same kind and system of bank-notes. Typical bank money (or “credit currency”) consists of notes issued by banks on the credit of their general assets, without special regulation by law. Many of the bank-notes issued by the banks chartered by either the federal or the state governments before the Civil War were of this kind; but after 1837 the notes of the Second Bank of the United States, which had been prudently controlled, were retired. The experience with many (not all) of the state bank-notes issues thereafter, until the Civil War, was less fortunate. As it was to the interest of the banks to keep in circulation as many notes as possible, many banks yielded to the temptation to abuse the power of note issue. The period is known

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as that of “wild-cat” banking. In 1866 a federal tax of 10 per cent on state bank-notes made their issue unprofitable.

Since the passage of the Federal Reserve Act we have temporarily two kinds of banknotes, the old bond-secured notes, in use since 1863 (very different from the typical form),9 and the new kind of Federal Reserve notes very nearly typical in character but issued only by the Federal Reserve banks, not by individual banks.

A bank, by the issue of notes, puts into circulation as money its own promises to pay. The customer, in borrowing money or in withdrawing deposits or cashing checks and drafts from other banks, is paid with the bank’s notes instead of with standard money. These notes may be returned to the issuing bank, either to be redeemed in specie or to be paid in some other form of credit, such as deposits or exchange. The limit of the issue of such notes is the need of the community for that form of money, and if they are promptly redeemed in standard money on demand, they never can exceed that amount. A holder of a note (in the absence of special regulations) has the same claim on the bank that a depositor has.

§ 10. Divergent views of typical bank-notes. Some persons, seeing in bank-notes but a form of ordinary commercial credit (like the promissory note or an individual’s check), have contended that their issue should be entirely unlimited and unregulated except by the ordinary law of contract which makes the bank liable to redeem the notes on demand. Such bank-notes would not be legal tender, and every one would be free to take or refuse them as he pleased. Each bank would thus put into circulation as many notes as it could; and, as they would constantly be returned for redemption when not needed as money, their volume would expand and contract with the needs of business.

It may be conceded that there is much truth in this view, but not the whole truth. For, in reality, when bank-notes are in common use, every one is compelled to take the money that is current. This offers a constant temptation to the reckless and unscrupulous promotion of banking enterprises, as has been repeatedly shown, notably in America in the days of “wild-eat” banking. The average citizen cannot know the credit of distant banks, and thus has not the same power of judging wisely in taking bank-notes that he has even in making deposits in the bank of his own neighborhood. Between bank-notes and ordinary promissory notes there are other differences. Bank-notes pass without endorsement, and thus depend on the credit of the bank alone, not, like checks, on the credit of the person from whom received. Unlike ordinary promissory notes, they yield no interest to the holder. They go into circulation and remain in circulation for considerable time by virtue of their monetary character in the hands of the holders. Thus they approach political money in their nature, and the banks are near to exercising the sovereign right of the issue of money.

At the other extreme of view have been those who consider bank-notes to be essentially of the nature of political money. If they are so, it is argued, the power of issue should not be exercised by any but the sovereign state. In this view it is overlooked that bank-notes, unlike inconvertable paper money, depend for their value on the credit of the bank, not on their legal-tender quality and on political power.10

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They must be redeemed on penalty of insolvency; government notes need not be, and yet will circulate at par if properly limited. Adequate provisions for the prompt return and redemption of bank-notes makes them “elastic” in their adaption to monetary needs, which fluctuate with changes in commerce and industry from season to season and even from day to day.

The predominent opinion to-day is that in their economic nature bank-notes share to some extent the character both of private promissory notes and of political paper money. In ordinary times they stand midway between the two, though in war financing they may virtually become merely fiat notes. Everywhere it has come to be held that the issue of paper money of any kind is in its nature a public monopoly, and yet everywhere the bank-note policy has come to be that of permitting the issue only to certain institutions, under strict public legislation and regulation, and of requiring in return for this privilege some substantial services of payments to the government.

§ 11. Banking credit as a medium of trade. The credit which, in various ways, banks sell11 serves, in most cases, the purposes of money to their customers. On the contrary, this is not usually true of time deposits, for the motive of the depositor in such cases is usually to invest his funds for a time rather than to keep them available as money. However, there are many cases in which persons save for some moderately distant use—such as the purchase of furniture, of a piano, of a house. The safety and convenience of time deposits, combined with the reward of a small rate of interest, cause great sums, in the aggregate, to be deposited as temporary savings, which otherwise would be hoarded in the form of money and thus withdrawn from circulation. In such cases the time deposit may serve both as an investment and as a monetary fund for future use. This is a great economy in the use of money, for experience shows that in the savings banks of America the average reserves of actual money kept against deposits are only about 1½ per cent. In countries where banks are little known, the amount of actual money hoarded is therefore vastly greater than it is in the United States, where there are $6,500,000,000 of individual deposits in regular savings banks, besides large sums in time deposits in commercial banks.

Demand deposits, while not money, clearly perform the function of a reserve of purchasing power for depositors, and reduce by so much the amount of money each must keep at hand to meet his current needs of purchasing power. If the depositor’s credit balance bears no interest, he has no motive to keep a balance greater than he would require of actual money, and he has the motive to spend it or invest it in income-bearing capital whenever his balance (plus his cash in hand) exceeds his monetary needs. Payment of interest on credit balances reduces the motive to withdraw for investment elsewhere any such excess, and mingles in the depositor’s thought monetary and investment motives. Demand deposits are often spoken of (somewhat inaccurately) as “deposit currency,” being funds at the command of depositors which are as disposable and as active and current for the monetary function as so much actual money would be. It is estimated that the rate of turnover of deposits in the United States is about fifty times a year. We may view the demand deposits subject to check as either a substitute for money or as a means by which the rapidity of circulation and the monetary efficiency of actual money held in bank reserves is multiplied manyfold.12

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The method of payment by bank drafts in domestic exchange reduces the need for, or increases the efficiency of, money in just the same way as does the use of checks. By the mutual credit of banks in different parts of the country, very large payments may be made in both directions with the movement of only the comparatively small amount of physical money needed to pay the balance after the cancellation of drafts, bills of exchange, and checks.

The use of bank-notes reduces the amount needed of other kinds of money more directly, though not more effectively, than do deposit accounts. Bank-notes are money, and as long as their amount is limited by prompt redemption they circulate instead of so much of other kinds of money. Redemption is possible by the use of a reserve of standard (or of legal-tender) money very much smaller than the amount of notes outstanding.

§12. Productive services of banks. There have always been some erroneous ideas regarding the magic power of banks to multiply the power of money. But there should be no more mystery about banking credit than about the nature of money itself. Banks are the labor-saving machinery of finance. They gather loanable funds, reduce hoarding, make money move more rapidly, and create a central market between borrowers and lenders for the sale of credit. While not creating more physical wealth directly, they add to the efficiency of wealth; they simplify and quicken the movement of nearly all commercial transactions. Banks perform incidentally a further service in developing better business methods in the community. They enforce promptness and exactitude in business dealings. In supplying credit to enterprises banks are constantly passing judgment on the collateral security presented to them and on the soundness of the enterprises that are seeking support. This gives to bankers great economic power, capable at times of misuse in political and social affairs, especially where a group of men comes to exercise a practical monopoly of business credit in any community, and uses this power for its own greedy and selfish ends.

§13. Earnings of banks. The earnings of banks are drawn from different sources, according to the size of the community and the nature of the banks. While in the villages and smaller cities the commercial banks perform a number of functions, in the larger cities they usually specialize in a far greater degree. The trust companies, however, with their greater versatility have been increasing in number. The earnings of banks are derived from discounts, interest on their own capital, charges for exchange and collection, dividends, interest and rents on investments, and profit from their bank-notes. The capital with which a bank starts in business13 could be lent with less trouble and more cheaply without starting a bank, but used as a banking capital it can be lent in part while still serving to attract deposits, which are the main source of the income of banks to-day. In the past it has been customary for many banks, especially “country banks,” to charge for remittances and for the collection of checks from other banks; but under the Federal Reserve system great progress has been made toward parity of exchange, or parity of checks, everywhere in the United States. While many small banks have strenuously opposed this because it cuts off a considerable source of revenue, they gain in other ways by performing this service freely for their customers. Banks make few investments in real estate or other physical property; it is, in fact, their duty to keep out of ordinary enterprises; but they are

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